Altria set to become a pure-play tobacco bet

U.S. cigarette business in decline, but overseas opportunities beckon

WilliamSpain

CHICAGO (MarketWatch) -- When Altria Group Inc. eventually spins off Kraft Foods Inc., its remaining Phillip Morris unit will be a pure-play tobacco investment for the first time in decades.

But despite a contentious and expensive litigation environment and increasingly restrictive regulations -- or, in many ways, because of them -- the tobacco company that remains is apt to sit astride its industry like a colossus for many years to come. It currently holds a 50% share of the declining but still enormous U.S. cigarette market and has been busily acquiring and launching new products elsewhere to build its piece -- currently about 15% -- of a global business that is still growing, although at a slower rate than in years past.

Those market-share numbers, along with the absolute dominance of its Marlboro -- arguably the world's best-known consumer brand -- are unlikely to move anywhere but up. With marketing regulations only getting tighter and the cost of entry always rising, its current competitors have enough trouble holding their own, and new ones aren't even on the horizon.

While it's not a done deal, Altria
MO, -1.12%
has made no secret of its desire to jettison its majority ownership of Kraft
KFT
when the time is right. The precise moment has been the topic of breathless speculation by Wall Street analysts, much of it premature, as the ever-cautious and methodical company has kept its own counsel.

Splits decision

And Kraft is the not only entity the company is looking at breaking off: It is also examining the possibility of splitting the tobacco business into foreign and domestic units. The two already have separate CEOs and provide their own investment presentations. And if many of the brands remain the same, there are stark differences in the challenges and opportunities faced at home and abroad.

No one at Altria would go on the record with MarketWatch to discuss current tobacco-industry trends or what a post-Kraft company might look like. But recent public remarks by top executives pull back the curtain a bit.

In the U.S., volume for essentially the entire industry is down, with the percentage of adults who smoke shrinking as more quit or die. And even those who continue to smoke often cut back, either out of economic necessity as the cost of cigarettes rises to above $8 a pack in some markets or because they have fewer and fewer places to light up.

In recent analyst meetings, Phillip Morris USA chief Michael Szymanczyk emphasized the company's market-share gains, court victories, the company's own anti-smoking efforts, and the development of new products like Taboka, a smokeless, spitless tobacco that's currently in test markets. At the same time, he acknowledged the ongoing volume declines -- down about 1% in the first half when adjusted for timing quirks.

The message from Phillip Morris International's CEO, Andre Calantzopoulos, has had a very different feel. The international unit boasted of volume growth of 6% -- to 804.5 billion smokes -- last year, helped along by acquisitions of Sampoerna in Indonesia and Coltabaco in Colombia and volume growth across Eastern Europe and in Turkey. It has by far the strongest single lineup of cigarette brands, with seven of the top 20 in its portfolio. Calantzopoulos can also talk of aggressive marketing efforts where permitted -- and there are a lot of places where they still are -- and growth in almost every single market outside of a few with unique problems, such as Germany and Spain.

'I think it's quite possible that international will be spun off, but that decision will be much further out than [a spinoff of] Kraft.'
Janice Hofferber, Moody's

In some countries, such as Mexico, Portugal, Italy and Argentina, the company's share is even larger than on its home turf. But in others Phillip Morris International has barely scratched the surface. It has almost no presence in six of the world's top 30 cigarette markets: India, China, Bangladesh, Iran, Pakistan and Vietnam.

Calantzopoulos put it this way: "While there will inevitably be bumps along the road, with nearly 85% of the world's adult smokers outside the USA that we will seek to persuade to switch to our products, I believe that Phillip Morris International has great potential to continue to expand volume, share and profitability going forward."

Trade barriers keep Phillip Morris International from getting full potential out of some foreign markets, while tax increases and smoking restrictions can disrupt consumption patterns in others. But what they don't have to worry about so much -- yet -- are multibillion-dollar lawsuits or governments that want to put them out of business entirely. After all, in many foreign countries, the state owns, or at least used to own, national tobacco monopolies, and smokers have long provided a major source or revenue. Top that off with legal systems that bar or discourage the award of large monetary penalties for corporate misbehavior (and aren't big on jury trials, either), and it's unlikely the Marlboro Man is going to get hauled before the bench anytime soon.

Home and away

All of these factors constitute a good argument for a further breakup, according to Gregg Warren, an analyst at Morningstar in Chicago.

"You could argue they could split the domestic from the international and just leave the domestic as a pure annuity for the states," he said, referring to the large sums cigarette companies pay to U.S. states under the 1998 Master Settlement Agreement. And even if American-style rules start to spread, as long as Phillip Morris International is already in a market, it could be a plus.

"When you have these kinds of marketing restrictions in place, it is very difficult to develop a brand," Warren added.

Janice Hofferber, a vice president at Moody's, said the ratings service already looks at the tobacco entity on its own and has it under review for a possible upgrade, although that is on "the improving litigation environment rather than prospects for the tobacco [business].

"I think it's quite possible that international will be spun off, but that decision will be much further out than [a spinoff of] Kraft," she continued. "International on its own has far higher growth prospects and potential for shareholders. A spinoff would also allow them to make acquisitions using the stock as currency."

Back to the U.S. side, there is little dispute that volumes will continue to decline and that the company is going to have to adapt. Morningstar's Warren said that "there will be some number where [the decline] halts, but I don't think anyone knows where it is."

He noted with approval the launch of Taboka, adding that "long-term they will probably end up buying UST
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That would be a good collateral move."

Of course, if current trends follow to their logical conclusion, there will in theory come a time when it will be impossible to turn a buck selling cigarettes here.

"But," said Hofferber, "I won't be covering the industry by the time it gets so low."

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